"Volcker Rule" Socks Bank Trading, Funding for Hedge funds and Private Equity

The fallout from the "Volcker Rule," President Barack Obama's proposal to ban banks from making speculative investments that do not benefit their customers, rattled stock and bond markets last week as analysts panicked over the possible repercussions.

At its heart, the plan would fundamentally change the banking industry, separating commercial banks from investment banks, a line that was muddled over a decade ago by the repeal of the Glass-Steagall Act.

"Never again will the American taxpayer be held hostage by a bank that is too big to fail," Obama said Thursday.

Obama announced the plan with former U.S. Federal Reserve Chairman Paul Volcker at his side. Volcker has been stumping for months for increased regulatory control, and the President credited him for the plan's design, dubbing it the "Volcker Rule."

In addition to curtailing private-equity and hedge fund investments, the plan bars banks from running proprietary trading operations solely for their own profit. Obama has argued that such speculative activity played a key role in the financial crisis. 

The administration also wants to limit the ability of the largest banks to use borrowed money to fund expansion plans, calling for expansion of a 1994 law that forbids banks from acquiring another bank if the deal would give it more than 10% of the nation's insured deposits.

When asked to assess the effect of the proposal, many analysts were concerned that the economic recovery put in jeopardy and the rebound in Standard & Poor's 500 Index earnings from a record nine-quarter slump will be curtailed.

"Authorities are certainly treading a fine line between curbing bubbles and choking off economic growth," Jim Reid, the London-based head of fundamental strategy at Deutsche Bank AG (NYSE: DB), wrote in note to investors obtained by Bloomberg News.

"Unintended Consequences"

Around the world, stocks and commodities took a hit on Thursday and Friday. The Dow Jones Industrial Average gave back much of last year's gains and commodities dropped to new 2010 lows.  Both crude oil and gold futures slipped in New York trading, retreating for three days in a row.

The bond market was also unsettled as investors demanded higher yields for corporate bonds.  The spread between Treasuries and corporate bonds widened to 272 basis points from the low this year of 266 basis points, or 2.66 percentage points, on Jan. 14, according to the Bank of America Corp.'s (NYSE: BAC) Merrill Lynch U.S. Corporate & High Yield Master Index.

Analysts worried that Obama's plan could permanently raise borrowing costs for U.S. businesses if banks respond to the rules by returning to tighter credit guidelines.

"All these regulatory actions could cause unintended consequences, including a greater perception of risk related to government intervention in the financial sector," Pri De Silva, a bank and brokerage analyst at debt research firm CreditSights Inc. in New York told Bloomberg.

Private Equity & Hedge Funds Are Losers

One of the key provisions in the new rules would prohibit banks that accept federally insured deposits or borrow from the Federal Reserve, from owning, investing in, or sponsoring hedge funds or private-equity firms.

That would change Wall Street's role in private equity funding, where financial institutions invest money to buy companies, real estate and other assets. U.S.
banks account for 9% of private-equity capital, having raised more than $80 billion for their private-equity funds since 2006, and investing $94 billion with other managers, according to Preqin Ltd., a London-based research firm cited by Bloomberg.

While financial institutions could still manage assets on behalf of clients, they wouldn't be able to invest in their own funds or those run by firms such as Blackstone Group LP (NYSE: BX) and KKR & Co.

The plan could force JP Morgan & Co. (NYSE: JPM) and Goldman Sachs Group Inc. (NYSE: GS) to shed their private equity businesses.  JPMorgan might have to sell its One Equity Partners private-equity business, which invests the firm's money. Goldman would have to jettison its private-equity business, which will be difficult because the unit invests its own money in the same funds that clients invest in.

But critics say targeting private-equity investments doesn't go to the root of the problems of the financial crisis and will only dry up funding.

"In a world where there is less capital available for private equity and hedge funds, this will take out another source of funding," Bruce Ettelson, head of the fund- formation group at law firm Kirkland & Ellis LLP in Chicago told Bloomberg.

Trading Operations Derailed

In addition to curtailing private-equity and hedge fund investments, the plan bars banks from running proprietary trading operations solely for their own profit.

"You can choose to engage in proprietary trading, or you can own a bank, but you can't do both," an administration official told The Wall Street Journal.

An analysis of five banks obtained by Bloomberg said Obama's proposals would hurt Goldman Sachs the most, resulting in an estimated $4.67 billion drop in sales in 2011.  It would cost Goldman Sachs, Morgan Stanley (NYSE: MS), Credit Suisse Group AG (NYSE: CS), UBS AG (NYSE: UBS) and Deutsche Bank a total of about $13 billion in revenue next year, according to JPMorgan analysts.

Banks Misused Funds

While many bankers and financial industry analysts were startled and disheartened by Obama's proposal, the argument can be made that the new regulatory storm can be blamed on the banks themselves.

In fall 2008, as the credit crisis was getting underway in earnest, investment banks Goldman Sachs and Morgan Stanley formally became banks - letting them access Fed bailouts and guarantees of their loan activity in financial markets.

As outlined by an in-depth Money Morning investigative series just as the financial crisis was peaking, the banks were able to borrow at low rates from the government's $250 billion "recapitalization" effort.

But instead of lending the money and pumping liquidity into locked up credit markets, the banks used billions of government money to buy out smaller rivals and turn profits trading for their own accounts by speculating in the market.

At the time, some of the banks even outright refused to discuss the matter.

"We have not disclosed that to the public. We're declining to," Thomas Kelly, a spokesman for JP Morgan told The Associated Press.

It's hardly a surprise that the government took notice of these shenanigans and is now seeking to rein back the banks activities.

"We started coming out of the rescue and you saw some of the biggest financial institutions . . . who had access to cheap financing . . . use that money without lending or anything, just doing their own investments," Austan Goolsbee, a member of the president's Council of Economic Advisers told the Washington Post. "That clearly started putting [the issue] on the radar screen for us."

The bank's moves gave Mr. Volcker and his allies new fuel for their argument that government-backed banks should be prohibited from taking big trading risks.

Thursday's announcement is just the latest move by the White House to target Wall Street and banks. 

The House already has passed a provision that would give regulators new authority to limit the size and scale of banks. Earlier this month, the president proposed a new fee on large banks and insurance companies that would raise $90 billion over 10 years to offset the costs of the bailout of financial firms and auto giants.

The fate of the Obama proposal is uncertain. But in a political environment clearly hostile to big banks, Democrats might need only a few Republican votes to enact the new rules.

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